Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Saving Face in China?

Three U.S. cosmetics companies look to this huge market to try to rejuvenate themselves.

China's definitely on everyone's minds these days. But have you stopped to think about what Chinese women will contribute to this booming economy?

That's the big question being asked by the major players in the Chinese cosmetics industry: Now that Chinese women have money to spend and faces no longer forced to conform to the "comrade" image, will they flock to the cosmetics counters of the big cities to purchase expensive products from the likes of EsteeLauder(NYSE:EL), Revlon(NYSE:REV), or Elizabeth Arden(NASDAQ:RDEN)?

Euromonitor thinks so. In a report published in September 2005, the research company said that "The cosmetics and toiletries industry in China extended its strong performance in 2004 with current value sales increasing by around 11% to reach over RMB67 billion [renminbi: a little over $8 billion U.S.] as growing affluence and greater product availability continued to fuel growth. . Euromonitor expects cosmetics and toiletries to experience robust growth of 55% over the forecast period to reach RMB104 [close to $13 billion U.S.] in constant value terms by 2009."

There's stiff competition for the largest dollop of China's cosmetics industry from companies such as France's L'Oreal and Japan's Shiseido. And Procter & Gamble's (NYSE:PG) Oil of Olay continues to outsell every other brand of whitening skin cream. But even more interesting, I suspect, for risk-tolerant investors (are there any other kind?) are the companies discussed below, which are looking to the East to rejuvenate their sagging sales.

EsteeLauder: Know your new customersSince 1953, Estee Lauder has produced or licensed a portfolio of 26 widely recognized brands. Despite brand recognition and diversity, the company has been struggling to make global headway. According to its first-quarter 2006 report, as of Sept. 30, 2005, sales in the U.S., as well as Europe, the Middle East, and Africa, were all flat compared with the same quarter a year ago. The only highlight came from Asia Pacific sales, which were up 5% to $198.6 million. This helped push overall net sales up a slight 0.5% to $1.5 billion.

But the cost of those sales was also up 3% , resulting in gross profit margins that declined to 72% from 73%. Net earnings went down as well, to $0.26 compared with $0.41, largely due to increased expenses. Another ongoing concern is that inventories continue to build up -- they are now at $815 million vs. the $713 million at the same time last year, an increase of 14% -- much faster than sales growth. Inventories are also 13% higher than when Alice Lomax worried about the situation in April of last year.

Despite these blemishes on its financial statements, I believe Estee Lauder has at least three things going for it that might reward a daring investor. First, the company recently demonstrated its commitment to its China operations by opening The Estee Lauder Companies Innovation Institute in Shanghai. The institute, according to the company press release, will work on "cutting edge research projects" and to "assess product safety and efficacy." But the more meaningful goals, in my opinion, include "developing local unique raw materials inspired by traditional Chinese medicine," working to achieve "tailor made, high quality products for the Asian consumer markets," and "conducting market research in order to better understand and meet Asian consumers' needs." Sounds to me like Estee Lauder is doing its best to get to know its Asian customers -- always a good strategy for long-term growth.

Secondly, Estee Lauder is essentially a family-owned and -run company. Insiders at the company own about 40% of the stock, with the Lauder family making up a good amount of that ownership. Although this can be a risk at times, it does show a high level of commitment to the company.

Thirdly, it looks like Estee Lauder's cosmopolitan cachet is wowing its Chinese customers, many of whom consider skin care and toiletries a worthwhile investment. A recent Fortune online article reported that the La Mer counter at an upscale mall in Shanghai had a list of 32 women waiting to purchase face cream for $1,700 U.S. per 16.5-ounce jar. The country's 2000 census reported that there are 612.28 million women in China. If a significant sampling of them are like Shanghai's La Mer customers, Estee Lauder should be reaping the rewards of product recognition and market dominance soon. (By the way, a 16.5-ounce jar of La Mer can be ordered online in the U.S. for a mere $1,200.)

Revlon: Breathtaking opportunity?Once upon a time, way back in 1998, Revlon's share price reached $56. Today, the company is trading in the neighborhood of $3. Sales have declined 18% since 2000, and the 2005 third-quarter report showed that net sales for the United States and Canada have declined by 19% compared with the same quarter a year ago (mostly due to increased selling, general, and administrative expenses).

But as with Estee Lauder, there's a bright (albeit tiny) spot on Revlon's horizon: Its net sales for the Asia Pacific and Africa segments of its "international market" increased by 4.2%, excluding the impact of currency fluctuations. (The company also experienced increased revenues in Europe and Latin America.) The company's 10-Q does not break out how much revenue was earned in China alone, but China Daily reported in January 2005 that Revlon "enjoyed high growth rates of more than 90 per cent" during 2004.

I find Revlon's ownership as intriguing as Estee Lauder's. Revlon is an indirectly majority-owned subsidiary of MacAndrews & Forbes Holdings, a corporation wholly owned by Ronald O. Perelman, whom Forbes describes as the "leveraged-buyout king." On more than one occasion, billionaire Perelman has paid big bucks to lift Revlon's public face, including a cash infusion of $125 million in November 2003 and a stocks-for-bonds swap in March 2004, which reduced the company's debt by $900 million. (Just a drop in the bucket, it would seem, because the company's total debt today is still a staggering $1.45 billion against total cash of $77 million.)

In 2002, Perelman hired Jack Stahl (the former president of Coca-Cola) as president and CEO of Revlon. So far, Stahl's endeavor has been so-so, share-price-wise.

But patient investors may want take into account the impact of Revlon's new strategic growth initiatives, launched in August 2005. According to the company, the first "involves a complete relaunch of the Almay brand and builds on Almay's healthy beauty heritage and the desire among consumers for simplicity and personalization." The second "is focused on the more mature consumer and involves the launch of a complete line of cosmetics under a new brand name that is designed to serve this affluent and growing consumer demographic currently underserved in the marketplace." Hmmm. "Healthy" beauty products for women "of a certain age?" Sounds like a sure winner for the U.S. female baby boomer market. If Revlon can do the same in China, it's sure to have a winner on its hands.

Elizabeth Arden: Curious China fantasyTom Gardner thinks Elizabeth Arden has a rosy outlook. In a recent Motley Fool Hidden Gems issue, he surmised that the company's shares "could climb in excess of 20% per year over the next five years." How much of this growth might be attributed to Arden's expansion into the China beauty market? Let's take a look.

The company was founded by "beauty culturist" Florence Nightingale Graham, who changed her name to Elizabeth Arden and later proclaimed, "There are only three American names that are known in every corner of the globe: Singer sewing machines, Coca-Cola, and Elizabeth Arden." Coke is certainly well-known in China today. Elizabeth Arden markets about 100 owned or licensed brands, so will Catherine Zeta-Jones (the face of Arden) be as recognizable as Coke in the near future?

Recently, Arden underlined its serious interest in pursuing the China market by purchasing Leroy, a distribution company based in Shanghai. The purchase was predicated by a 75% increase in sales over the last 2 1/2 years, which allowed the growing company to make China a priority for future business.

According to the company's 2005 annual report, international operations represented 38% of total net sales, compared with 33% the prior year, and the company experienced sales growth of 27% (or 20% on a constant currency basis). According to E. Scott Beattie, chairman and CEO, "We anticipate the northern Asia market will provide top-line growth for us for many years, and we will vigorously reinvest our cash flow to grow this market."

But even the rosiest predictions may have a blemish or two: During the latter part of 2005 and the end of the first quarter of 2006, Elizabeth Arden's Western European market dropped precipitously, and sales were also sluggish in North America. The company reported net income of $895,000, or $0.03 per share, versus earnings of $4.8 million, or $0.16 per share, during the same quarter last year. For the three months ended Sept. 30, 2005, Arden reported that net sales increased 7.2% over the same period in 2004 (driven primarily by the launch of the Fantasy Britney Spears fragrance), but were offset by a corresponding increase in selling, general, and administrative expenses. So although gross margins are high, the company still needs to increase its efficiency in maintaining costs.

But there's still the China syndrome: A recent Euromonitor report says that luxury anti-aging treatments (such as those Elizabeth Arden specializes in) are becoming more popular with Chinese women. If Elizabeth Arden can make its investment in China a success, the company is sure to be a leader in market share there.

Although all three of these companies provide intriguing growth prospects, investors will want to be sure to do their due diligence, examining balance sheets and free cash flow. They've all been through some rough spots recently, but the big question on investors' minds is this: Which company will determine the face (and skin tone) of China? The challenge will be to mix Western cosmetic characteristics with Chinese preferences; the U.S. companies that can do so will have the best shot at securing the largest share of the Chinese beauty market.

Fool contributor Ellen Dowling does not own shares in any of these cosmetic companies, but she wears Estee Lauder's Pleasures nearly every day. The Motley Fool has a disclosure policy.